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Vertical Mergers
Or Make VS Buy Outsourcing is Buy. Buying is buying the external output from outside source or externalising an internal process. Vertical Integration is Make. Making allows the firm itself to produce its own intermediate input for consumption Stop producing if the supplier is cheaper. Externalise is transaction costs are cheaper. Vertically integrate if transaction costs are reduced. * Down and Up * Down maximises profits first buying input from up. Up input price + own cost = total cost. Use final market demand * Maximise profits normally - (p-c)*market demand. Find the optimal price of Down. * Up then uses Down's optimal price in it's own profit maximisation. Instead of market price being used in the quantity function, the optimal price of Down is used instead. * Maximise for Up. Get optimal price. * Optimal price for down and up will be in terms of each other so equal and solve. Find the optimal prices and find profits. * When collaborating, combine the individual marginal costs and optimise to find one optimal price, quantity and profit. Rent Seeking ~> Rent and Quasi Rent. * Deciding to enter a contract will consume time and resources * Bargaining to get a better deal is inefficient. If parties anticipate being held up they will not enter negotiation. * Rent - economic return above minimum just to enter the agreement * Quasi-rent - economic return above the minimum needed to retain parties in agreement, economic rent above minimum necessary to maintain relationship. * If the investment is specific to the relationship then the contractor is more motivated to stay in the relationship/contract * The difference between what you get from staying in the contract and what you get from deviating and going with another/none at all is the quasi-rent. The higher the quasi-rent, the more likely you will stay with the original. * EG * Rent ** Agreed upon price P ** As long as k(P-C) > I then go into contract ** The rent for you would be k(P-C)-I > 0 ** If P* is the lowest price at willing to go into contract then I = k(P*-C) ** k(P-P*) * Quasi-Rent ** If deal doesn't work out then sell to other as long as Pm > C ** Quasi Rent with ford is then k(P-Pm) ** Different between rent and quasi rent is k(P*-Pm) * After fulfilling contract, the client can try to renegotiate (rent seeking behaviour). Since I is already sunk the client can afford to do this and gain the quasi-rent difference k(P*-Pm) as long as P>=Pm or P=P*. Integration and Asset Specificity * Integration can stop haggling * Haggling depends on contractual-completeness, when the contract covers all aspects of relationship then there is less need to haggle. Integration rises as more appropriable quasi-rent increases * Once one party has made a relationship to engage in relationship and once this happens then the party will hold up, ie attempt to renegotiate the deals of the contract * Presence of quasi-rent may cause hold up and parties anticipating this will avoid investment, underinvest and invest in wasteful protective measures * Asset Specificity * Site - keep the assets close to each other to reduce transportation cost on inventory and transportation * Physical Asset - physical assets have to be "fit" to the relationship-specific use * Dedicated - Monopsony: investments made to satisfy a single buyer * Human Asset - employees learning relationship specific skills and knowledge * Hold up arises from asset-specificity and non-contractability * If returns from the asset are not measurable/transferable then parties will do wasteful rent-seeking activities but when assets are integrated this can be solved. Contractual Incompleteness * Contracts specify what to do in a relationship * A contract can't cover absolutely everything(costly) so contractual incompleteness is unavoidable * Unforeseen stuff happens and screws things up * * Adaptation * Under integration, the contractor becomes the worker under the boss * Under non-ntegration there is no coordination under uncertainty in decisions but under integration the boss can tailor decisions to the uncertainty * Adaptation-exploitation theory: integration allows the matching of decisions to the evolving environment but does not take account of the exploitation of the workers * Rengotiations not possible, can allocate decisions rights, can't specify decisions. In this case: worker expropriation or boss expropriation. * For low-profit return, worker control preferred. This is non-integration and better because boss control would lead to under-investment. * For high-profit, boss control is preferred. This is integration and better because workers would invest escessively. * If profit is between medium and low, the there is a dilemma. Integration/Non-integration preferred under different circumstances depending on probability.